1. Field of the Disclosed Embodiments
The disclosed embodiments relate to electronic trading of funds, electronic funds management, and real-time fund processing systems
2. Background of the Disclosed Embodiments
The majority of collective investment vehicles holdings are in the form of mutual funds, exchange traded funds, exchange traded notes, trust vehicles, and other similar collective arrangements. These collective arrangements have the benefit of bundling a collection of assets and other financial contracts into a single investable instrument for an investor. Depending upon the related investment strategy and the anticipated target investor audience, one form of collective arrangement may typically be preferred (e.g. exchange traded fund or “ETF”, exchange traded note or “ETN”, mutual fund, or other).
Investment vehicles provide an important service to the individual and (non-financial) institutional investor. Such vehicles warehouse and manage a collection of assets, liabilities and other financial contracts. They allow investors to access instruments, returns and market directionality that are otherwise unobtainable in conventional investments or only obtainable at prohibitive expense and complexity.
The availability of these vehicles is an important public policy matter; they serve to reduce or eliminate the structural disadvantages which smaller investors may suffer. That is, smaller investors generally traffic in a less complete, less comprehensive, and less competitively priced marketplace, and new vehicles and products can bridge that gap.
A more recent extension of the collective investment vehicle has been vehicles which purport and attempt to provide investors with investment returns which are either: (a) inversely related to the movement in a related index (the “inverse Return Vehicles”); or (b) positively related to index returns and amplified through a leveraging arrangement (the “Leveraged Return Vehicles”).
Inverse Return Vehicles enjoy positive returns when the related index declines in value. For example, an Inverse Return Vehicle on U.S. equities would increase in value as the U.S. equity index it tracks declines. Inverse Return Vehicles may have a negative 1-times return target, or a multiple inverse target such as negative 2-times the related index returns.
On the other hand, Leveraged Return Vehicles enjoy amplified returns relating to the applicable index. For example Leveraged Investment Vehicles on a foreign currency would enjoy increased value if the foreign currency appreciated. The level of increase or gain in the fund would be magnified by a multiple of the leverage.
Public Policy Considerations
The availability of sophisticated collective investment vehicles is an important public policy goal. An equally pressing public policy goal should be to engineer (or reengineer) collective investment vehicles which deliver accurate strategies and returns to the investing public. As of Mar. 31, 2011, the market capitalization of leveraged (or structured) funds exceeded US$20 billion.
Existing structured funds are subject to delivering returns which can and have deviated materially from their investment objective. The market response to the deficiency in performance has been to tweak the disclosure to limit the applicability of the fund's headline strategy to a single trading day. Existing structured funds are subject to considerable tracking error from the linked index. In addition, not only do large tracking errors occur, but funds have sometimes delivered an entirely erroneous return in the opposite direction to what the fund purports to deliver (e.g. based on index movements, a fund should be up 10%, but instead the fund is down 20%).
The U.S. Securities and Exchange Commission (SEC) addressed the matter in a release entitled “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors”, August 2009; see (http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm). In response to the SEC release and commentator criticism, the fund community largely responded by tweaking fund disclosure to absolve the funds from suitable performance for periods which extend beyond a single trading day. A typical example of structured fund disclosure is as follows:
“ . . . [the fund] seeks a return of −100% of the return of an index (target) for a single day (before fees and expenses). Due to the compounding of daily returns, returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor holdings consistent with their strategies, as frequently as daily . . . ”
Source: ProShares Short S&P500 Fact Sheet as of Sep. 30, 2010.
To further illustrate the problems in current trading methodology, attention will be turned to FIG. 1 and FIG. 2. FIG. 1 is a set of four tables containing historical daily return data for four indices including Oil, Gold, BKX, and DJ TECH. BKX is the KBW (Keefe Bruyette & Woods) Large Cap U.S. Bank Index currently comprised of the 24 largest U.S. banks. DJ TECH is the Dow Jones U.S. Technology Index and is comprised of all of the major publicly listed U.S. technology stocks with a current constituent list of 163 companies. Oil is the Brent London daily fixing. Gold is the London daily fixing. Each table contains the time period from which the returns were drawn in a footnote.
FIG. 2 is a set of four return comparison graphs which incorporate the 5-Day return series from FIG. 1. In each panel of the figure, all four indices are run through: (i) “Target” which is the arithmetically correct 5-Day return given the related return sequence, and (ii) “ETF” which applies the typical industry methodology. Beginning with the panel in the upper left-hand corner and moving clockwise, the panels indicate the following fund targets: (1) a −1× inverse fund, (2) a −2× inverse fund, (3) a +3× positively leveraged fund, and (4) a +2× positively leveraged fund. Each index is indicated along the x-axis, and percentage return is indicated along the y-axis.
FIGS. 1 and 2 demonstrate the shortcomings of the typical industry methodology. FIG. 1, as indicated, contains selected daily return data for four popular investment indices; oil, gold, U.S. financial stocks, and U.S. technology stocks. The daily returns indicated in the figure were selected because they were periods of maximum annualized volatility for the time periods indicated in each table. FIG. 2, as indicated, uses the 5-Day return series for each of the four indices, and runs the return series through: (i) a target return calculation which is the algebraic multiplication as indicated below (“Target”), and (ii) the conventional ETF applying the typical industry methodology indicated as “ETF” in the Figure.
In FIG. 2, “Target” indicates the return an investor should receive (without errors created by the known methods) and can be indicated as below for a 2-times leveraged fund:Target Return=2×[−1+(1+R1)×(1+R2)×(1+R3)×(1+R4)×(1+R5)]
where R(t) is the daily return for day “t.”
In FIG. 2, The ETF return uses the algorithms currently in use by all structured funds. The typical industry methodology does not use a system to generate accurate share returns, but instead relies on a simple compounding of assets, a leveraging of gains and de-leveraging of losses, and constant leverage of debt. In the context of a 2-times leveraged fund, existing finds use equations essentially equal to:Assetst=Assetst-1×(1+2×Rt)Debtt=Debtt-1+Assetst-1×Rt 
where, R is the periodic market return on the indicated assets.
The return for a share holder in existing funds is based on the change in price of his share holdings from period to period, and the share price for any period will be:Pricet=[Assetst−Debtt]/Sharest 
where, Shares is the outstanding number of shares as of the related determination.
FIG. 2 illustrates four bar graph return comparisons. Inverse funds are present on top (a −1× fund on the left, and a −2× fund on the right), and leveraged funds are presented on the bottom (a 2× leverage fund on the left, and a 3× leveraged fund on the right). Each graph contains all four indices and both methods of return (“Target” is the algebraic return which should be delivered in an accurate fund, and “ETF” is based on the typical industry methodology).
Across all four target returns (−1×, −2×, +2×, +3×) and across all four indices (DJ Tech, BKX, Oil, and Gold), the typical industry methodology delivers (i) a directionally incorrect return for the inverse BKX funds and the inverse oil funds, (ii) large tracking errors and material underperformance in all of the DJ Tech funds and in the leveraged BKX and leveraged Oil, and (iii) small underperformance in all Gold funds. Existing fund methods do not match the Targeted return in any of the examples and existing fund methods consistently underperform. For simplicity, fees and other costs are excluded from the analysis.
Consistent with FIG. 1 and FIG. 2, the investor educational materials published by one of the largest structured ETF providers, ProFunds Group (a.k.a. ProShares), confirm the short-comings of the typical industry methodology, including return failures for periods longer than a single day, and underperformance in the presence of market volatility—underperformance relating to volatility applies to any investment period where return directions vary.
Currently published on the ProFunds website under “Understanding Long-Term Performance: The Universal Effects of Compounding and Leveraged Funds” (web address immediately follows), ProFunds indicates:                “2× leveraged fund—A fund designed to provide twice (200%) the daily return of an index or other benchmark. (These funds do not attempt to produce the return during any period other than a day. Results for longer than one trading day will likely differ from the return of twice the index over the longer period.)”        “The effect of compounding can help returns in upward- and downward-trending markets and hurt in volatile markets, assuming all other variables remain the same. Investors should recognize that over time this effect can be magnified significantly in leveraged funds. The use of leverage generally increases the risk of investing in the funds. Leveraged funds are not suitable for all investors. Investors should actively monitor their holdings consistent with their strategies, as frequently as daily.”        
(http://www.profunds.com/pricesperformance/content/universaleffectsofcompounding.html)
The unfavorable attention from the Securities and Exchange Commission relating to the short-comings in existing funds dating back to August 2009, and the current disclosure (November 2011—above web address from the largest fund company in structured ETF indicates a long felt need for novel innovation in the area. Data from FINRA (the U.S. Financial Industry Regulatory Authority) indicate that sales of structured investment to retail investors increased at a rate of 38% from 2009 to 2010 further indicating a long felt need for innovation in the tracking of returns of investment funds based on the increasing demand and usage of structured investment instruments. For example, the article at the web link discloses:
“The Universal Effects of Compounding and Leveraged Funds                Compounding is a universal mathematical concept that affects the returns of investments. It is important for all investors to understand how compounding affects returns in different market conditions—upward-trending, downward-trending and volatile. For leveraged fund investors, it is particularly important to understand that the effect of compounding on leveraged funds is significantly magnified and can cause gains and losses to occur much faster and to a greater degree.        Compounding with unleveraged investments:        Let's take a look at how compounding affects unleveraged returns in upward-trending, downward-trending and volatile markets.        When ‘10+10=21’        In an upward-trending market, compounding can result in longer-term returns that are greater than the sum of the individual daily returns. An investor who starts with $100 in an investment that grows 10% a day for two consecutive days would have $121, or a 21% gain. This is greater than the sum of the individual day returns, or 20%.        When ‘−10+−10=−19’        In a downward-trending market, compounding can also result in longer-term returns that are less negative than the sum of the individual daily returns. An investor who starts with $100 in an investment that declines 10% a day for two consecutive days would have $81, or a −19% return. This is less negative than the sum of the individual day returns, or −20%.        When ‘10+−10=−1’        In a volatile market, compounding can result in longer-term returns that are less than the sum of the individual daily returns. An investor who starts with $100 in an investment that rises 10% on one day and declines 10% the next would have $99, or a −1% return. This is less than the sum of the individual day returns, or 0%.        When ‘20+20=44’        In an upward-trending market, compounding can result in longer-term leveraged returns that are greater than two times the return of the unleveraged investment. An investor who starts with $100 in a leveraged fund that grows 20% a day (2×10% index gain) for two consecutive days would have $144, or a 44% gain. This is greater than two times the 21% compound gain of the unleveraged investment.        When ‘−20+−20=−36’        In a downward-trending market, compounding can also result in longer-term leveraged returns that are less negative than two times the return of the unleveraged investment. An investor who starts with $100 in a leveraged fund that declines 20% a day (2×10% index decline) for two consecutive days would have $64, or a −36% return. This is less negative than two times the 19% compound loss of the unleveraged investment.        When ‘20+−20=−4’        In a volatile market, compounding can result in leveraged longer-term returns that are less than two times the return of the unleveraged investment. An investor who starts with $100 in a leveraged fund that rises 20% one day (2×10% index gain) and declines 20% the next (2×10% index decline) would have $96, or a −4% return. This is four times less than the −1% compound return of the unleveraged investment (see sidebar). Compounding can also result in returns that are in the opposite direction of the underlying index during periods of unusual volatility.        Does compounding affect the returns of conventional index funds? If so, why don't I see it?        Over time, compounding can make returns of an indexed investment either greater than or less than the simple sum of the individual daily returns. However, this effect is not easy to see by merely comparing the return of the investment versus the return of the index. The reason? Conventional indexes such as the S&P 500 and the Dow Jones Industrial Average have the effect of compounding incorporated into their returns.        Why aren't the longer-term returns of a 2× leveraged fund normally two times the return of its underlying index?        The impact of compounding on a 2× leveraged fund is generally greater than twice the impact of compounding on an equivalent unleveraged investment. As a result, the longer-term return of a leveraged fund can be significantly greater than or less than two times the return of its underlying index for the time period. For instance, the leveraged fund return in the volatile market example on this page (third example) results in a 4% loss, a much greater loss than two times the 1% loss in the unleveraged volatile market example (third example).        In summary        The effect of compounding can help returns in upward- and downward-trending markets and hurt in volatile markets, assuming all other variables remain the same. Investors should recognize that over time this effect can be magnified significantly in leveraged funds. The use of leverage generally increases the risk of investing in the funds. Leveraged funds are not suitable for all investors . . . ”        
The disclosed embodiment is distinguished from the state of the art in the elimination of adverse path dependency. Under adverse path dependency, if the periodic index movements change direction (i.e. the index return series is not monotonic), the beneficial interests in such investment vehicles will underperform the targeted index. Even worse, returns in the state of the art funds may deliver returns opposite of those intended in periods of high market volatility. FIG. 2 is an illustration of the adverse path dependency in conventional funds.
As highlighted in the above referenced SEC release, the current state of the art investment vehicle performance may diverge from its intended course when measured over more than a single trading day. The disclosed embodiment, by contrast, causes trading of beneficial “interests” or “shares”, referred to herein as “units”, to accurately track the intended course for extended periods of time. As a consequence, the system outlined in the disclosed embodiment introduces a beneficial long term aspect to the securities market, investing and risk management in contrast to the one day speculative nature of the current fund arrangements. Further, aggressive end-of-day asset rebalancing in existing fund structures may contribute to undesirable market volatility and the disclosed embodiment eliminates return related asset rebalancing under normal market conditions.